Credit: The 2-day devastation inflicted on the market following the shocking Brexit vote has been long forgotten. Since then the market has rallied to new heights despite many pundits calling for a prolonged pullback. Year to date the S&P 500 is up 7% and over 200% after bottoming out in 2009, marking one of the greatest bull markets in history.
The recent hot streak isn’t sitting well with everyone though. There are growing concerns that the rally has inflated prices to the point where they are beginning to look expensive. Rising multiples without improving earnings has driven lofty valuations. All the main valuation tools support this ongoing trend, yet investors don’t seem to be bothered.
When the market hit bottom in February, the S&P 500 was trading at 15.2 times forward earnings, about average by historical standards. Since then the index has gained steam and today trades at 17.5 forward earnings. This marks the most expensive valuation multiple since 2008 and among the highest levels in the past 12 years. It is more alarming that in the trailing 12 months the S&P 500 has been trading at nearly 25 times earnings. The market would need to see a broader pullback for it to meet the estimated trading multiple a year from now.
Valuations are frighteningly higher when you consider the Shiller P/E or CAPE ratio. The Shiller P/E is often viewed as a more accurate measure since it uses adjusted earnings over a 10-year horizon, rather than 12 months, to calculate value. The current Shiller P/E ratio implies the market is trading at 27 times earnings, slightly greater than conventional metrics.
The Buffett Indicator, on the other hand, does not measure the market’s value based on earnings, but as a ratio of market capitalization to GDP. If the relationship falls in the range of 70% to 80%, buying stocks is likely advisable. If the ratio approaches 200%, as it did in the run-up to the dot.com crisis, you are playing with fire. The current indicator is sitting just below its 52 week high of 123.5%. Even at its lowest point of the year, the measure hasn’t dipped below 100%.
Overvalued markets have historically stemmed from irrational exuberance, but with investors more cautious than ever that doesn’t appear to be the case.
Persistently low interest rates and the increasing popularity of buyback programs can be largely credited or blamed for rising valuations. Income investors accustomed to investing in bonds have been forced to equities as yields draw down, thereby driving stock prices and valuations up.
Meanwhile, buyback programs are becoming more commonplace through this low growth environment. They are used to not only reward shareholders, but boost earnings per share, the standard metric used to calculate valuation. Maintaining dividend and repurchasing programs in coming quarters will help support this bull market while organic earnings growth catches up.
Both low rates and capital return programs have distorted market valuations in recent years. Stocks that were was once considered expensive and overvalued are now being viewed as fairly priced, which raises the question of whether or not traditional tools like P/E are apt measures of current and future conditions.
The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.
The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.
